Category Archives: growth vs value

MSFT’s 3Q11: signs of Windows weakness

May 2, 2011 By in earnings conference calls, growth vs value, Industry Analysis, internet, Stock ideas, Technology, Video games Tags: , , , , , , , , , , , , Leave a comment

the results

After the close of the market in New York on Thursday April 28th, MSFT reported its 3Q11 (MSFT’s fiscal year ends in June) results.  The company earned $.56 per share for the three months (+24% year on year), on revenue of $16.4 billion (+13%).  A non-recurring tax benefit raised the final per share tally by $.05, to $.61.  This compares with the Wall Street consensus estimate of $.56.

MSFT shares dropped by 3% in Friday trading, in a flat market for IT.  INTC, the second member of the “Wintel alliance,” whose shares tend to  trade more or less in line with those of MSFT, rose, in contrast, by 1.5%.

the details

picky points (symptoms of analyst’s disease)

–MSFT continues to show impressive control of operating expenses.  Despite this, operating income for the quarter was up by only 10.3% year on year.  That’s less than the rate of increase in revenue–not what you’d expect from a software company.

–The company spent $10.3 billion, or a tad less than 60% of net income, over the first nine months of fiscal 2011 buying back its own stock.  That’s far above the $2.2 billion in new issuance (presumably from exercise of employee stock options) over the same period.  Outstanding shares are down by about 4% year on year–meaning around 4% of the advance in per share income comes, not from an increase in the bottom line, but from shrinkage of the denominator used in the calculation.

more important things

MSFT has five divisions, two big ones, one medium-sized and two that you can safely ignore if you just want a general picture of where growth is likely to come from.  In size order, giving the percent of operating income each represented in fiscal 2011 to date, and year on year growth for 3Q11, the divisions are:

Business (meaning MS Office and related productivity tools)      43.5% of operating earnings, 24.5% year on year growth in 3Q

Windows (the PC operating system)          38.7% of operating earnings, 10% year on year decline

Server and Tools          20% of operating income, 11.7% year on year growth

Entertainment + Devices (X-Box, cellphones…)          5.4% of operating income, 50% year on year growth

Online Services          -7.6% of operating income (a loss of $1.8 billion), a 10.% increase in the year on year loss.

the numbers need a bit of tweaking

Windows 7  launched in late October 2009.  So year-ago sales were flattered by the rush to buy the new product (and ditch Vista).  Office 2010 debuted in June 2010.  Anyone who bought Office 2007 in the runup to launch of the new version got a free upgrade.  Revenue was booked when the upgrade was redeemed, not when the sale was made–meaning that revenues in the Business segment during the year-ago quarter were unusually weak.

MSFT thinks the true rate of the Business segment revenue growth was 13%, not the 20% reported.  Conversely, it believes the decline in the PC market it saw in 3Q11 was 1%-3%, less than the 4.5% drop in sales it posted.

MSFT’s take on the PC market…

According to the company, netbook sales were down 40% year on year, business PCs were up 9% and consumer PCs were down 8%.  MSFT thinks that emerging markets represent “nearly half” of global PC shipments.

…vs. INTC’s

In simple terms, INTC (see my latest post on the company) is saying that the lion’s share of PC growth is coming in the emerging world, where consultants like Gartner or IDS, who are projecting lackluster growth in the PC market this year, have limited ability to collect data.  The two consultants are mistakenly extrapolating the present weakness in the US and Europe to include the developing world.  As a result their unit sales projections are too low.  INTC, which does over half its business in developing countries, says it has a much better look at demand through its warehouse and sales staffs–and business is better than the consultants think.

In a nutshell, MSFT sees the same picture the consultants do.

my thoughts

I don’t think netbooks are an important factor.  If they comprised 5% of the total PC market a year ago and that’s been cut in half, the resulting unit volume decline is 2.5%.  But they use low-cost Atom processors and Windows 7 Starter, which does little more than start the machine.  So they’re not a commensurate revenue loss.  Also,  to some degree buyers have switched to low-end laptops, which carry higher revenue and profits for both MSFT and INTC.

Macs are a factor, but not the key one, in my opinion.  Macs are growing much faster than the overall PC industry.  They use INTC chips but the AAPL operating system.  However, although Macs represent over 10% of the PCs sold in the US, they’re less than 4% of the world’s unit purchases.  Yes, they’ve been gaining half a point to a point of market share per year, but that probably means less than a 1% unit volume increase for INTC.

The MSFT management didn’t respond to an analyst’s question about piracy, which, in my experience, is rampant in the Pacific.  My guess is that non-branded “white box” computers with unauthorized copies of Windows software are a big part of the difference between MSFT’s experience and INTC’s.  There’s no way of knowing for sure, though, so MSFT’s judgment not to broach the topic is probably its best tack.

One other interesting MSFT management comment about INTC:  The MSFT CFO suggested that maybe the biggest reason for INTC’s good results was its ability to raise prices.  Although he didn’t say this, what seemed to me to be implied is that INTC can raise prices in a way MSFT can’t.  In other words, through constant innovation in chip size, speed, power consumption, INTC has a better value proposition for customers than MSFT does.  I think that’s right, but it’s funny to hear it from the lips of MSFT.

the stock

MSFT is guiding to a 4Q11 about in line with results from 3Q11.  This would bring full-year results to about $2.60 a share.  I think we’ve already seen the crest of the current product cycle with the launches of Windows 7 and Office 2010.  So fiscal 2012 will likely show eps growth at a much slower pace than the likely 24% gain this year.  Let’s pencil in 12%.

If so, the stock is trading at about 9X forward earnings, has net cash of around $4.50 a share, generates free cash flow and yields about 2.5%.  That looks cheap to me.  It’s hard to figure where the upside is going to come from, though.  Certainly, there are isolated interesting products, but I’m not sure there’s anything big or dramatic enough to move the needle for a giant like MSFT and engage investors’ imaginations. So value-oriented investors, the prime potential buyers of MSFT, may well worry that the stock will remain the “value trap” it has been for the last decade.




the curious case of David Sokol and Berkshire Hathaway

April 8, 2011 By in book value, Securities regulation Tags: , , , , Leave a comment

The case of David Sokol, late of Berkshire Hathaway, has been widely reported over recent days.  The facts, as I understand them, are as follows:

Sokol’s behavior…

1.  One of Warren Buffett’s chief lieutenants and touted as a potential successor to the Sage of Omaha, Mr. Sokol had the task of finding a suitable target for the merger and acquisition “elephant gun” Mr. Buffett proclaimed last year he had primed to fire.  There may have been others looking as well, but Mr. Sokol certainly was one.

2.  Mr. Sokol decided to recommend Lubrizol to Mr. Buffett as a company that Berkshire should purchase.

3.  Prior to approaching his boss, Mr. Sokol bought $9+ million in Lubrizol stock for himself.

4.  In his presentation to Mr. Buffett, Mr. Sokol mentioned his own holding, but only in passing.  He apparently did so in a way that it didn’t highlight the relevant points of how recent or how large his purchase had been.

5.  Buffett decided to buy Lubrizol.  Sokol sold his stock for a $3 million personal profit.

6.  After this became know, Sokol resigned from Berkshire.  Buffett maintains that Sokol did nothing wrong and that the resignation has nothing to do with his Lubrizol stock purchase.

7.  The SEC is now investigating Sokol, with the focus of the inquiry on whether there are other instances of the same buy-for-yourself-then-recommend behavior.

…isn’t the issue on Wall Street.  Buffett’s is.

People buy Berkshire Hathaway stock because they regard Warren Buffett as a master investor and a person of absolute integrity.  His public appearances draw immense media attention for the same reasons.  Other investors parse each sentence he pens or utters for sophisticated investment insights.  Why, then, would such a hero defend a subordinate who appears to have taken advantage of Mr. Buffett’s trust and used his corporate position for personal gain?   …especially when this conduct appears to fly in the face of the fair-play rules every investment company must follow.

why do this?

No one outside Berkshire Hathaway knows for sure.  I have two observations:

1.  Imagine what Mr. Sokol’s defense against charges of failing in his fiduciary duty to Berkshire Hathaway shareholders might be.  If it were me, I’d argue along three lines:

a) First, I would say that Sokol is an industrialist working for a conglomerate, not a portfolio manager working for a regulated securities company.  Therefore, he’s not subject to the severe controls on the latter’s activities.

b)  I’d then say that Berkshire doesn’t have adequate compliance procedures that establish and monitor standards of conduct.  As as result of this corporate failure, he was ignorant of proper procedures.

c) Then I’d try to argue that his behavior was common practice at Berkshire.

In fact, it appears Sokol is already asserting that what he did is just the same as Charlie Munger (Buffett’s long-time associate and vice-chairman of Berkshire) holding shares of Chinese battery company BYD prior to Berkshire taking a large stake.

In the press, there has been no discussion of Berkshire compliance procedures.  Yes, Buffett wrote a letter on the subject all newly hired executives are required to state that they have read–but nothing else.  No one I’m aware of has written that Berkshire implemented the kind of strict controls over, and intense scrutiny of, personal trading that is mandatory for investment companies.  Nor is there talk of periodic compliance training that is also required for professional investors.  My guess is that, while these procedures may exist in the company’s insurance subsidiaries, there’s no company-wide effort.

Also, if it is correct that the thrust of an SEC investigation of Sokol is on a pattern of behavior rather than this one incident, this suggests that points a) and b) above have merit.

To sum up, at least in the very narrow sense of “can he be convicted?”, Mr. Sokol may actually have done nothing wrong.  Unethical, maybe, but illegal, no.  So there’s little Mr. Buffett can do other than to ask for Mr. Sokol’s resignation.

Ironically, if Berkshire were a regulated investment company, it may well be that Mr. Buffett’s supervisory failure to publicize and enforce the rules would be the main actionable offense.

2.  There could be a second reason for Berkshire wanting to put this incident behind it as quickly as possible.

The shock and outrage in the investment community over the Sokol affair illustrates Wall Street’s belief about what Berkshire is:  the investment company run by one of the greatest American investors of the twentieth century.

To defend itself, Berkshire would likely have to emphasize that Berkshire is a financial services/industrial conglomerate (Geico is its best-known brand), not a regulated investment firm.

What’s so bad about that?  The stock doesn’t trade at the discount to asset value that’s characteristic of multi-industry companies, insurance firms in particular.  Berkshire trades at a substantial, though slowly shrinking, premium to book.   Defense of Berkshire’s behavior regarding Sokol might well end up being an attack on that premium as well, and accelerate its decline.

 

the Flatotel and the Alex Hotel: a cautionary tale for investors

April 6, 2011 By in distressed assets, growth vs value, Investment firms, Private equity, Property/housing Tags: , , , , 1 Comment

a free Wall Street Journal

I’m not a particular fan of News Corp, even though I will admit I was one of the first US-based holders of the stock–and a large one at that–in the mid-Eighties.  The Wall Street Journal is being delivered to my door every day this week as part of a campaign to gain new subscribers, however.  Yes, there’s a lot of fluff and it’s very US-centric.  But the paper is better than I remember.  To my surprise, I may end up subscribing.

That’s not my point today, though.

the underbelly of finance

The “Greater New York” section of yesterday’s paper has an interesting article in it that gives a glimpse at a part of the usually-hidden underbelly of finance.  It also shows some of the obstacles that investors in “deep value” or “distressed” assets routinely face.

Titled “Hotel Developer Must Check Out,” the article describes a recent foreclosure action in which a New York judge put two Manhattan hotels, the Flatotel and the Alex, into receivership.

Alexico

The back story is about a former gold trader and a hotel developer who met in the gym and formed a hotel management company, Alexico.  Borrowing heavily from Anglo Irish Bank (the institution, incidentally, that played the pivotal role in crashing the entire Irish economy), the two started a number of high-end hotel and condominium projects. Then the great recession came.

Anglo Irish has since been nationalized.  As part of its restructuring, it sold the loans it made Flatotel and Alex–a face value of $258 million–to a consortium of US real estate management groups for maybe half that.  They went to court to force Alexico to turn over control of the two hotels.

That’s not the interesting part.

the interesting part

This is:

–the two hotels are losing money   They haven’t made payments on their debt, nor have they paid real estate taxes, for two years.  But they did manage to pay Alexico $570,000 in management fees during that period.

–in addition, the ailing hotels scraped together enough cash to lend $5.3 million to other parts of the (now crumbling) Alexico empire.

–why didn’t Alexico extract even more money from the two failing hotels, you may ask?  A cynic, meaning someone who’s seen this movie before, would say that what Alexico took was all the cash the hotels were generating.

–besides this, the plaintiffs in the case say the hotels’ financial records are a mess (what a surprise!). No elaboration, but I don’t think the issue is that the accountants spilled coffee on the books or that the entries are all mixed up and in the wrong places.  I interpret this as meaning there’s no way of knowing how much money came in the hotels’ doors or tracing where it went.  If so, there may be more money missing than the loans.

All of this is pretty standard fare.  But there’s typically more:

–were the hotels larger, we’d probably also be talking about their employee pension plan–who manages it?  did it too lend money to other parts of Alexico?

–if Alexico built the hotels instead of buying them, we’d likely also be asking about whether the structures are up to code, or if the construction company used lower-quality materials than specified in the contracts.

when the burden of proof shifts…

As a general rule, it’s a mistake in a situation like this to think either  1) that this is the first time the people involved have done something like this, or 2) that what you’ve discovered to date is everything they’ve done to the asset in question.

This is why it takes a certain mindset to navigate through the potential minefield of a distressed asset.  All in all, I’m happier being a growth stock investor and leaving this sort of analysis to someone else.

cash flow per share and earnings per share as valuation metrics (ll): cash flow per share

January 27, 2011 By in Accounting, cash flow, cash flow/share vs. earnings/share, depreciation, growth vs value Tags: , , , , , , , , , Leave a comment

investor preferences

A large number of investors in the US want to buy stocks where the underlying companies are growing profits rapidly.  The same is true in many other stock markets of the world.  For such investors, earnings per share growth is the main metric they look for when transacting.

This isn’t an immutable law of equity investing, however.  To a large degree, the search for growth is also a question of investor preferences.  In the US, the market I have the longest experience with, I’ve seen the mix of price and growth that investors prefer change dramatically several times.  This has been not so much because the macroeconomic environment has changed, but because the personal circumstances of investors (their age and wealth) did.

Also, I’ve seen other markets where preferences are quite different, where a “good” stock is one that pays a high dividend and where the company is mature enough that it has little need to spend capital on expansion.  These are markets where the search is for income, not for growth.  Taiwan in the 1980s is the first strong example I’ve encountered personally (technology stocks there couldn’t list unless they were willing to pay a 5% yield!).   But the US in the pre-WWII era seems to me to have been another.

the search for income

Not every company can grow at a rapid clip of a long time.  As well, some companies temporarily experience declining profits, either because the economy has turned against them cyclically, or because they’ve just lost their way.  In any of these cases, the large group of investors I’ve mentioned above lose interest in the stocks and more or less consign them to the equity junk pile.

There’s a whole set of other professional investors–in fact, in the US they are arguably in the majority–who evaluate stocks not on their earnings growth potential but on the companies’ ability to generate cash from operations.  There are many variations on this approach.  But all use cash flow per share as their main tool.  Such investors calculate an absolute worth for the company (usually a present value of cash flows over, say, ten years) and compare that with the share price.  They buy what they hope are the most undervalued stocks.

Around the globe, such value investors expect that at some point either the company’s fortunes will take a cyclical turn for the better, or that other investors will realize the undervaluation they see, or (in the US at least) that pressure will be brought to bear on the company to improve its operations.

[By the way, about two years ago, I wrote a series of posts on growth investing vs. value investing that you might want to read.  Take the test (which of two stocks would you buy) to see if you've got more growth or value tendencies.]

the stock as a quasi-bond

The key to this approach, viewing it through my growth investor eyes, is to regard the stock as a quasi-bond.

Let’s say the firm is now generating $1 a share in cash from profits and $2 a share in cash from depreciation and amortization.  That’s $3 a share in yearly cash flow.  Taking a ten-year investing horizon, the company will generate a total of $30, even with no growth at all–if the firm can get away without serious new capital investments.  If we were to assume that the company could achieve an inflation-matching rise in cash flow, then the present value of the stream of cash flow is $30.  (Yes, this is a vast oversimplification, but it is the thought process.  Remember, too, we’re also figuring there’s nothing left after ten years.)

What would a company like this sell for on Wall Street?  $20 a share?  …less?

We do have a yardstick, since if we reverse the profit and depreciation figures the description in the last paragraph is a rough approximation of INTC.  The value investor’s explanation for serious undervaluation is that people are so worried about the possibility that processors using designs from ARM Holdings will gradually eat in to INTC’s markets that they are overlooking the latter’s substantial cash generating power.

happy vs. unhappy shareholders

Another way of putting the difference between looking at earnings per share and cash flow per share–

–investors look at eps to gauge a firm’s value when they’re happy with the way the company is performing;

–they look at cash flow per share when they’re not, when they’re trying to figure out how much the company would be worth with different management, or in private hands, or after being acquired by a competitor.

The risk the first group takes is that all good things eventually come to an end.  The worry of the second group is that they’ve be unable to pry the company out of the hands of current management.

Chinese mergers and acquisitions in Japan on the rise?

December 16, 2010 By in Asian economic development, book value, China, economics, growth vs value, Hong Kong, Japanese development Tags: , , , , Leave a comment

Bloomberg published an article yesterday in which it pointed out that merger and acquisition activity by mainland China and Hong Kong companies in Japan is up by more than a third so far this year, to $437.7 million.  (The same article gives the figures, but doesn’t do the math, to show that this amount is about 0.5% of the money Chinese companies have spent on m&a globally over the same period.)  Must have been a slow news day.

Is there anything of significance here, though?

Maybe.  …or maybe I’m just having a slow news day.  In any event:

1.  The targets are small companies.  Larger firms are effectively protected against foreign acquisition by legislation enacted during the first of Japan’s “lost decades,” the Nineties.  Unlike most other places, Japanese tax law (as I understand it) no longer regards all bids where the acquirer offers to exchange shares of his stock for those of the target as being tax-free exchanges.  Instead–but only in the case of a bidder offering stock in a non-Japanese corporation–people tendering their stock are subject to special punitive taxes.

One unintended result of this protection, I think, is that ex the auto companies many major Japanese firms have fallen farther behind their global rivals.

2.  American and European “activist” investors–hedge funds and private equity–have been stunningly unsuccessful at plying their trade in the small company arena in Japan over the past twenty years.

Western financial investors have been enticed by very attractive financial metrics (lots of net cash, how price to book, low price to cash flow) and the existence of bunches of “low-hanging fruit,” in the form of very inefficient work practices.

They’ve typically quietly acquired a substantial ownership stake in a target company and then approached management with proposals for change, including cost-cutting and layoffs.  Management refuses.

The westerner starts a proxy fight but gets no support from domestic institutions and loses.

The westerner tries to increase his stake, so he can force changes, but finds that the target’s customers and suppliers counter these efforts by buying up stock that will vote in favor of current management.

The net result:  the westerner is stuck in a highly illiquid position in a poorly managed company–and no one will buy his stock to allow him to exit.

3.  There’s little love lost between Japan and China.  The real issue, I think, is not recent territorial disputes between the two.  It’s the history of Japanese militarism in Asia in World War II and earlier.  …that and gestures like PM Koizumi’s visit to the Yasukuni Shrine in Tokyo, which suggest a lack of remorse for wartime atrocities.

4.  There is one big difference between the western approach to small Japanese firms and the Chinese one.

In the former case, financial investors wanted to change the Japanese operations of their targets in ways that were culturally unacceptable.

In the latter, investors may want to acquire either relatively low-tech craft skill–how to operate a retail chain in an environment with a complex web of distribution partners, how to deliver fresh food frequently to convenience stores.  Or the target may either have Asian distribution rights for western products, or options on those rights, or long relationships that will help substantially in securing those rights.

Chinese investors are willing to leave the Japanese operations of their targets to wither on the vine.  They want technology they can transfer to the mainland.

Investment implications?  No direct ones that I can see.  You certainly don’t want to fool around on the low-tech small-cap Japanese arena, in my opinion.  My guess is that we’ll see very rapid growth in the Chinese companies that benefit from Japanese craft skill.

Two things to note:  the targets are all involved in domestically oriented businesses, suggesting the transformation of the mainland economy in this direction may take place more rapidly than the consensus expects.  Also, it’s interesting that from a quality of life perspective, Chinese investors see the mainland and Japan as not being that dissimilar.

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